S&P Sector Rotation Strategies

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CME Group’s E-mini S&P Select Sector Stock Index futures offer an “efficacious and convenient tool” for asset managers seeking to put contrarian viewpoints to work and capitalize on anticipated shifts in health care, technology and other key U.S. industries.

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S&P Sector Rotation Strategies

  1. 1. EQUITY MARKETSSector Rotation StrategiesAUGUST 10, 2012John W. Labuszewski Richard CoManaging Director Executive DirectorResearch & Product Development Equity Products312-466-7469 312-930-3227jlab@cmegroup.com Richard.co@cmegroup.com
  2. 2. CME Group E-mini S&P Select Sector Stock Index investments from one sector to another whilefutures (Select Sector futures) debuted in March leaving the core investment portfolio undisturbed.2011. The indexes underlying the nine (9) differentfutures contracts represent subsets of the Standard Select Sector Performance& Poor’s 500 (S&P 500). Specifically, these indexesrepresent the consumer discretionary (IXY), The Standard & Poor’s 500 is the most popularlyconsumer staples (IXR), energy (IXE), financial referenced benchmark depicting the performance of(IXM), health care (IXV), industrial (IXI, materials the U.S. equities market. It is comprised of(IXB), technology (IXT) and utilities (IXU) sectors of securities drawn from ten well defined industrythe economy. 1 sectors as indicated above.The associated futures contracts are cash-settled to While all of these indexes are positively correlated toa value of $100 x Index with the exception of the the “mother” S&P 500 Index, the betas (β) andFinancials contract which is valued at $250 x Index. coefficients of correlation (R2) derived from a statistical regression of sector index returns vs.These contracts may be utilized for purposes of those of the S&P 500 vary widely.taking outright risk exposure or hedging riskexposure in any of the 9 industry sectors. Select Sector Performance vs. S&P 500 (Based on Weekly Data from 7/2/10 – 6/29/12)Or, they may be utilized to take advantage of Index Symbol Beta (β) R2anticipated trends in the relative performance of two Consumer Disc IXY 1.032 0.907different sectors. This may be referred to as a Consumer Staples IXR 0.513 0.712“sector rotation strategy” insofar as one may shift Energy IXE 1.327 0.825 Financial IXM 1.301 0.878resources from poorly performing sectors into Health Care IXV 0.709 0.780sectors expected to exhibit superior performance. Industrial IXI 1.186 0.941 Materials IXB 1.295 0.853 S&P 500 Sector Breakdown Technology IXT 1.008 0.883 (As of 6/29/12) Utilities IXU 0.467 0.498 IXU IXY 3.80% 10.88% Source: Bloomberg IXT IXR 22.82% 11.44% The utility index exhibits a conservative beta of 0.467 and a weak correlation of 0.498. The energy and financial indexes have very aggressive betas of IXE 1.327 and 1.301, respectively. The industrial sector IXB 11.17% is most heavily correlated with the S&P 500 with an 3.34% R2=0.941. IXI 10.35% This suggests a simple strategy of shifting away IXM IXV 14.25% from low beta into high beta sectors in anticipation 11.95% of a bull market in equities. Or, shifting away from high beta and into low-beta sectors in anticipation ofSpecifically, Select Sector futures may be utilized to a bear market.comprise a spread transaction on the part ofspeculative interests. Or, they may be used by Summary performance data for the S&P 500 and theequity asset managers to allocate or rotate 9 Select Sector Indexes is provided in the appendix below. Over the past 5-year time period from July 2007 through June 2012, the S&P 500 has been essentially flat with a total return (inclusive of price fluctuations plus dividend accruals) of 1.10%.1 Note that the info-tech and telecom sectors of the S&P 500 were combined to comprise the technology select sector index.1 | Sector Rotation Strategies | August 10, 2012 | © CME GROUP
  3. 3. But the various Select Sector Indexes have Spreading Select Sector Futuresgenerated widely divergent returns over the sameperiod. The consumer staples sector is up 48.05%; Speculators frequently utilize inter-market spreadstechnology is up 21.54%; and, health care is up to take advantage of anticipated differentials in the20.10%. By contrast, the financial sector was down performance of one market vs. another. Select54.39%. This result may generally be attributed to Sector futures lend themselves ideally for thisthe continued fallout from the subprime mortgage purpose.crisis which has hit the financial services industryvery hard. Thus, investors had generally shifted In order to place an inter-market spread, it isinvestment into more downturn resistant industries necessary to derive the so-called “spread ratio.”such as consumer staples. The spread ratio is an indication of the ratio or number of stock index futures that must be held in S&P 500 Sector Indexes the two markets to equalize the monetary value of 1,200 the positions held on both legs of the spread. 1,150 Dec. 31, 2011 = 1,000.00 1,100 Financial:Industrial Spread Ratio 1,050 1.20 1,000 950 1.15 900 Ratio = ($250 x IXM) / ($100 x IXI) 850 1.10 800 1.05 750 700 1.00 6/30/11 7/31/11 8/31/11 9/30/11 1/31/12 2/29/12 3/31/12 4/30/12 5/31/12 10/31/11 11/30/11 12/31/11 0.95 IXY IXR IXE IXM IXV 0.90 Sep-11 Jan-11 Jan-12 Mar-11 May-11 Jul-11 Mar-12 May-12 Nov-11 IXI IXB IXT IXU SPXOver the past year (July 2011-June 20112), themarket was led by utilities (+15.13%), consumerstaples (+14.72%) and technology stocks The following formula may be used for this purpose(+13.85%). Energy (-10.25%) and materials stocks where Value1 and Value2 represent the monetary(-8.35%) were the major losers over this period. value of the two stock index futures contracts thatThis result may be attributed to nervousness in the are the subject of the spread. 22nd half of 2011 driven by the European sovereign 𝑆𝑝𝑟𝑒𝑎𝑑 𝑅𝑎𝑡𝑖𝑜 = 𝑉𝑎𝑙𝑢𝑒1 ÷ 𝑉𝑎𝑙𝑢𝑒2debt crisis and declining domestic interest rates.This pushed investors into utilities offering highdividend yields and the other downturn resistant E.g., on February 25, 2011, the S&P Financial Selectindustries. Energy and materials stocks were Sector index was quoted at 168.10. Thus, the E-generally off on falling oil prices and weakening mini S&P Select Sector Financial futures contractemerging market demands. was valued at $42,025 (=$250 x 168.10). The E- mini S&P Select Sector Industrial futures contractOn a year-to-date (YTD) basis, the market was led was valued at $36,910 (=$100 x 369.10).by technology stocks (+13.85%); financials(+13.71%); and, consumer discretionary stocks(+12.95%). Over the same period, energy stockshave fallen (-3.00%). This result may be traced tomodest economic strength on the one hand; and, 2 We reference spot index values and not the quoteddeclining energy prices on the other hand. futures price for purposes of identifying the monetary value of a stock index futures contract. This convention serves to eliminate cost of carry considerations from the calculation.2 | Sector Rotation Strategies | August 10, 2012 | © CME GROUP
  4. 4. The spread ratio is calculated below at 1.139. This Or, one might utilize CME Group E-mini S&P 500suggests that one might balance 10 Financial index Select Sector stock index futures similarly tofutures with 11 Industrial index futures. restructure the portfolio. Specifically, one may transact a spread by selling E-mini Industrial Select Spread Ratio = ValueFinancials ÷ ValueIndustrials Sector futures and buying E-mini Financial Select = $42,025 ÷ $36,910 Sector futures. = 1.139 = 10 Financial:11 Industrial E.g., assume that the manager of an equity portfolio valued at $100 million wanted to “overweight”Thus, if one believed that industrials might financials by 5% and similarly “underweight”outperform the financial sector of the market in industrials by 5%.early 2011, one might wish to sell 10 FinancialSelect Sector futures and buy 11 Industrial Select This would imply the purchase of 119 FinancialSector futures contracts. Sector futures [=(5% x $100 million) ÷ $42,025]) coupled with the sale of 136 Industrial Sector If Industrials futures (=1.139 x 119). Sell 10 Financial & expected to  Buy 11 Industrial outperform Buy 119 Financial futures Effectively over- Financials Sector futures & weights financials by Sell 136  5% & under-weightsThe “spread ratio” provides an indication of the Industrial Sector industrials by 5%appropriate way to construct an inter-market futuresspread. Further, it presents a convenient methodfor following the performance of the spread over Thus, the asset manager effectively maytime. Because these ratios are dynamic, one must “underweight” industrials and “overweight” financialsbe aware of the current spread ratio when placing a relative to the benchmark against which histrade. performance is measured – presumably the S&P 500. But this strategy utilizing futures spreads toSector Rotation Investment Strategy shift resources from one sector to the next offers the advantage of leaving undisturbed the underlyingEquity asset managers will generally allocate their equity investments weighted according to thefunds across stock market industry sectors and benchmark. Thus, this may be referred to as anindividual stocks. In many cases, they may conform “overlay” strategy.the composition of the portfolio to match that of thebenchmark or bogey. This strategy assures that the Similarly, one may use stock index futures to rotateperformance of the portfolio generally will parallel investment from one national stock market toperformance of the benchmark. another. E.g., one might sell E-mini S&P 500 futures and buy E-mini S&P CNX Nifty futuresHowever, asset managers may subsequently re- effectively to rotate investment away from U.S. andallocate, or rotate, portions of the portfolio amongst into Indian equity markets.these various sectors in search of enhanced value. ConclusionE.g., noting that the financial sector of the economyhas performed poorly relative to other sectors CME Group E-mini S&P Select Sector Stock Indexincluding industrials in recent years, an asset futures represent an efficacious and convenient toolmanager might adopt a “contrarian” viewpoint to the to pursue “sector rotation” strategies, by shiftingeffect that financials may bounce back in coming resources or investment from market sectorsmonths. Thus, he may re-allocate investment away expected to underperform to sectors expected tofrom industrial stocks in favor of financial stocks. outperform the market.This may be accomplished simply by liquidatingindustrial stocks in favor of buying financial stocks.3 | Sector Rotation Strategies | August 10, 2012 | © CME GROUP
  5. 5. Appendix: Summary Performance Data (6/29/12) Ticker Q2 2012 YTD 2012 1-Year 5-Year Index Index (Bloom- Total Total Total Total Level berg) Return Return Return Return S&P 500 SPX 1,362.16 -2.76% 9.49% 5.43% 1.10% Consumer Discretionary IXY 438.38 -2.60% 12.95% 10.71% 5.09% Consumer Staples IXR 347.35 2.77% 8.48% 14.72% 48.05% Energy IXE 666.63 -6.98% -3.00% -10.25% 5.09% Financial IXM 146.30 -6.83% 13.71% -2.69% -54.39% Health Care IXV 381.88 1.67% 10.91% 9.55% 20.10% Industrial IXI 356.25 -4.26% 6.62% -2.12% 2.91% Materials IXB 371.73 -4.09% 6.35% -8.35% -0.29% Technology IXT 288.57 -4.27% 13.85% 13.85% 21.54% Utilities IXU 373.63 6.53% 4.82% 15.13% 15.04% Source: BloombergCopyright 2012 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futuresare a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than theamount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affectingtheir lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on everytrade. All examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be consideredinvestment advice or the results of actual market experience.”Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within themeaning of section 1(a)12 of the Commodity Exchange Act. Swaps are a leveraged investment, and because only a percentage of acontract’s value is required to trade, it is possible to lose more than the amount of money deposited for a swaps position. Therefore, tradersshould only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted toany one trade because they cannot expect to profit on every trade.CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks ofChicago Mercantile Exchange Inc. Chicago Board of Trade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is atrademark of the New York Mercantile Exchange, Inc.The information within this document has been compiled by CME Group for general purposes only and has not taken into account thespecific situations of any recipients of the information. CME Group assumes no responsibility for any errors or omissions. Additionally, allexamples contained herein are hypothetical situations, used for explanation purposes only, and should not be considered investment adviceor the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are supersededby official CME, NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases before taking any action.4 | Sector Rotation Strategies | August 10, 2012 | © CME GROUP

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